Wednesday, March 31, 2010

Investors Urge Reform of Mortgage Securities Market

Original posted on the Housing Wire by Diana Golobay:

Mortgage investors are urging detailed reform of the asset-backed securities (ABS) market that would ensure private sector demand for mortgages in a post-Fed market.

The Federal Reserve today completes $1.25trn of agency mortgage-backed securities (MBS), stirring industry fears mortgage bond spreads to Treasuries could blow out again if private investor demand fails to replace the Fed’s significant demand.

The Association of Mortgage Investors, a group representing institutional investors and asset managers, sent a letter (download here) to Congress and regulators this week detailing “guideline principals” for reforming the ABS market.

The letter recommended issuers be required to provide loan-level information that investors, rating agencies and regulators can use to evaluate collateral and its expected economic performance, both at pool underwriting and continuously over the life of a securitization.

The letter also suggested a required “cooling off” period when ABS are offered so investors have time to review and analyze loan-level information before making investment decisions.

The association recommended that deal documents for all ABS and structured finance securities be made publicly available to market participants and regulators. The letter also urged Congress and regulators to directly address conflicts of interest arising when servicers have economic interests adverse to those of investors.

“Investors provide the capital that make securitization markets work yet the lessons learned over the last three years demand greater transparency and empowerment of investors for them to be comfortable buying mortgage products in the future,” said Micah Green, association spokesperson and partner at regulatory law firm Patton Boggs, in a press statement.

Green added: “It is important for the government to consider the policy recommendations of investors, whose participation and capital are needed for there to be a viable mortgage-backed securities market, particularly if the role of Government in the mortgage market could change in the future.”

Loans without backing are focus of Redwood offering

Original posted on the Wall Street Journal by James Hagerty and Nick Timiraos:

Redwood Trust Inc. is trying to reopen the market for securities backed by home-mortgage loans without any government backing, according to people familiar with the situation.

These people say the Mill Valley, Calif., mortgage-investment manager may launch as soon as next week an offering of such securities totaling at least $200 million, though the deal could be postponed if market conditions aren't propitious.

The transaction would be the first sale in more than two years of private-label securities backed by newly originated home mortgages. Other firms recently have issued private-label securities containing mortgages that were made in past years.

The market for private-label mortgage securities—those not backed by Fannie Mae, Freddie Mac or any other government-controlled entity—dried up more than two years ago when a surge in defaults killed investors' desire for such bonds.

If the Redwood transaction is successful, it could mark a small but important step toward healing a market that has been so devastated that it has become almost entirely dependent on government backing.

The Redwood securities would be backed by "jumbo" mortgages, or those too big to be backed by government agencies. Jumbo-lending volume has fallen sharply because banks have to hold those loans in their portfolios, and that has put pressure on the upper end of the housing market.

Redwood declined to comment.

At the peak of the housing boom in 2006, private-label mortgage securities accounted for 56% of the $2 trillion in mortgage securities sold to investors, according to Inside Mortgage Finance, an industry publication. But the private-label market has been nearly dead since the third quarter of 2007.

Even if the market's first offering is successful, it isn't likely to trigger an immediate rush of new issues. That is partly because lenders aren't originating large numbers of nongovernment-backed mortgages. The maximum size of "conforming" loans—those that can be sold to Fannie Mae or Freddie Mac—has risen to $729,750 in the priciest housing markets, up from $417,000 during the housing boom. As a result, most home buyers can get a conforming loan rather than a jumbo, which carry higher interest rates. Sales of higher-end homes in many markets have been sluggish, further reducing the supply of mortgages tied to the homes.

Investors could be attracted to deals right now because credit quality is strong, fueled by loan underwriting standards that are near the tightest levels in at least a decade. "You will see a couple of folks get out there and get these deals done in the next couple months," says Paul Bossidy, chief executive of Clayton Holdings LLC, who is working on a separate transaction.

The prospect of renewed interest from some private investors in mortgage bonds comes as the Federal Reserve on Wednesday is set to end its $1.25 trillion in purchases of mortgage-backed securities that has helped keep mortgage rates near record lows.

Meanwhile, the Association of Mortgage Investors, a trade group, on Tuesday issued a set of "guiding principles" to Congress and regulators with suggestions on how to revive private investment in mortgages. "Investors provide the capital that make securitization markets work," said Micah Green, a partner at the law firm of Patton Boggs LLP, who represents the association. But, he said, "the lessons learned over the last three years demand greater transparency and empowerment of investors for them to be comfortable buying mortgage products in the future."

Among other things, the association called for more information on individual loans that are put into pools of mortgages backing securities and more time for investors to review that data before making decisions.

Tuesday, March 30, 2010

Key Members of the House Financial Services Committee Introduce U.S. Covered Bond Legislation

Posted on website of Alston & Bird by Tara Castillo:

Yesterday, key members of the House Financial Services Committee, Ranking Member of the Capital Markets Subcommittee, Scott Garrett, (R-NJ), Chairman Paul Kanjorski, (D-PA) and Ranking Member Spencer Bachus (R-AL), introduced the United States Covered Bond Act, that “aims to help facilitate a robust covered bonds market in the U.S. to add liquidity and certainty to our nation's capital markets.” A section-by-section summary of the legislation has also been made available.

Covered bonds are debt securities with 2-10 year maturities traditionally backed by cash flows originating from mortgage and public sector loans. Covered bonds typically receive high credit ratings and are retained on the issuer’s balance sheet. The covered bond market has been used primarily in Europe to help provide additional sources of funding for issuers and serves as a primary source of liquidity for the European mortgage industry. The regulatory framework set forth in the Garrett-Kanjorski-Bachus legislation seeks to provide similar benefits in the U.S. market. Last December, the House Financial Services Committee held a hearing on covered bonds and discussed the potential for a U.S. covered bonds market to provide stable, long term liquidity to the financial system. Congressman Garret stated in connection with the proposed legislation that “[a]s the U.S. continues to recover from the financial crisis, it is essential that Congress examines new and innovative ways to unthaw our locked credit markets and encourage private capital to confidently re-engage by turning cash now on the sidelines into active investments in our country’s future,” He also emphasized that “a robust U.S. covered bond market would offer numerous benefits to investors, consumers, and the broader financial sector, ensuring longer term liquidity that is more stable for U.S. credit markets.”

The framework of the proposed legislation establishes regulatory oversight of covered bond programs, includes broad provisions for default and insolvency of covered bond issuers and subjects covered bonds to applicable securities regulations by federal regulators. Further, the proposed legislation directs the U.S. Securities and Exchange Commission to “develop a streamlined registration scheme for other covered bonds that are not otherwise exempt securities.”

Under the proposed legislation eligible asset classes include the following classes of assets:

  • residential mortgage;
  • home equity;
  • commercial mortgage;
  • public sector;
  • auto;
  • student loans;
  • credit or charge card;
  • small business; and
  • such other asset classes designated by the covered bond regulator.

The proposed legislation is a follow-up to Congressman Garrett’s original legislation, The Equal Treatment for Covered Bonds Act that was introduced in 2008. Also in 2008, the U.S. Treasury Department and the FDIC published a list of Best Practices and a final policy statement respectively which addresses the issues of creating and regulating a covered bond market in the United states.

Many industry participants have welcomed the proposed legislation. In particular the Commercial Mortgage Securities Association which issued a press release yesterday that noted that creating a U.S. covered bond framework “should ensure that U.S. financial institutions, consumers and borrowers have a level playing field and equal credit opportunities.” The CMSA was invited as a select witness to provide testimony at the December House Financial Services hearing.

Monday, March 29, 2010

Rating Agencies in the Face of Regulation

By Milton Harris, Professor of Finance and Economics at the University of Chicago, Christian Opp, Ph.D. Candidate in Finance at the University of Chicago, and Marcus Opp, Assistant Professor of Finance at UC Berkeley.

In our paper, Rating Agencies in the Face of Regulation – Rating Inflation and Regulatory Arbitrage, which was recently made publicly available on SSRN, we develop a rational expectations framework to analyze how rating agencies’ incentives are altered when ratings are used for regulatory purposes such as bank capital requirements. Rating agencies have been criticized by politicians, regulators and academics as one of the major catalysts of the 2008/2009 financial crisis. One of the most prominent lines of attack, as voiced by Henry Waxman, is that rating agencies “broke the bond of trust” and fooled trustful investors with inflated ratings. However, should sophisticated financial institutions be realistically categorized as trustful and fooled investors in light of the fact that they interacted with rating agencies not only as investors but also as originators of subprime mortgage securities? Why would these institutional investors care about ratings when they knew about rating agencies’ practices?

We argue that a first-order benefit of a high rating stems from financial regulations, such as minimum bank capital requirements. Over the last 20 years bank capital requirements (Basel I guidelines (1988) and Basel II guidelines (2004)) have become increasingly reliant on ratings as a measure of risk. For example, banks must hold five times as many reserves against BBB+ securities than against AAA securities. Moreover, the investment-grade threshold and the AAA threshold have become regulatory investment restrictions for pension and money market funds. Since these regulations are of first-order relevance for institutional investors’ capital management, a AAA label is economically valuable, independently of the underlying information it provides about the risk of a security.

Consistent with these observations, we develop a rational-expectations model of the “rating game” in which institutional investors face regulatory constraints that are contingent on ratings. The model reveals that regulation may, at least in part, reconcile rating inflation in select asset classes, low risk premia and investment by rational investors that are aware of the rating agencies’ practices. We show that regulatory benefits for highly rated securities distort the rating agency’s incentive to acquire information. If these benefits are above a threshold, the rating agency stops to acquire information and simply engages in rating inflation: the rating agency effectively becomes a regulatory arbitrageur rather than a provider of information. This extreme result is more likely to occur for complex securities that are costly to evaluate. Two observations may be explained by this result: the apparent low effort by rating agencies to create sophisticated models for the mortgage market, an area outside of the rating agency’s primary expertise, and the fact that exotic, structured securities receive a much higher percentage of AAA ratings (e.g., 60% for CDOs) than do corporate bonds (1%, see Fitch (2007)).

Interestingly, the effect of regulatory benefits is ambiguous below the threshold level at which rating agencies in our model produce no information. It is possible that the rating agency acquires more or less information in response to an increase in regulatory benefits. We show that these comparative statics depend on the distribution of types in the cross-section. If there is a large fraction of bad types and a few exceptionally good types, the rating agency will acquire less information, enabling more securities to be classified AAA. In the opposite case, the rating agency increases its information acquisition. A gradual shift in the distribution towards bad types, such as the inclusion of subprime mortgages, would therefore reduce information acquisition and hence would lead to a less efficient allocation of funds in the economy.

The full paper is available for download here.

Credit card ABS supply slows to trickle in Q1

Original posted on Reuters by Nancy Leinfuss:

Sweeping changes to the securitization landscape this year prompted a retreat by credit card issuers from the U.S. asset-backed market in the first quarter.

After leading supply over recent years, credit card securities accounted for a paltry $1 billion of the $28 billion in asset-backed securitizations sold through the first quarter.

A tougher regulatory and legislative environment combined with new accounting rules and tighter lending standards have all worked to clamp down on credit card ABS supply this year.

Accounting changes requiring lenders to move securitizations, once held in separate bankruptcy remote trusts, back on to their balance sheets has reduced the appeal of securitization as a funding tool for some issuers.

"Securitization will lose its capital advantage in many cases now that ABS programs have to be consolidated on bank balance sheets," said John McElravey, analyst at Wells Fargo Securities.

With credit card securitizations now weighing on bank balance sheets, other worries are also emerging concerning the treatment of the securities by the Federal Deposit Insurance Corp in the event of a bank failure.

"A lot of potential issuers are waiting on a final ruling on the safe harbor for securitizations. Issuers need a more definitive answer that these assets can't be taken in a bankruptcy," said William Bemis, portfolio manager at Aviva Investors.

The safe harbor was originally created so that investors could rely on securitized assets for payment without concern that the assets would be interfered with by the FDIC in the event of a bank failure.

In addition, Senate Banking Committee Chairman Christopher Dodd's revised U.S. financial regulation reform bill is seen as the next step in a long push by the Obama administration and congressional Democrats to tighten bank and capital market oversight after the financial crisis.

"Senator Dodd's proposal, combined with regulatory reform legislation in the House and the FDIC's safe harbor rule, will likely have a significant effect on the consumer ABS market," said Ajay Rajadhyaksha, analyst at Barclays Capital.

The FDIC recently extended its safe harbor provision through Sept. 2010, grandfathering all new securities issued under its old plan, until a final decision on the treatment of the securities is hammered out.

In the meantime, credit card issuers are turning toward other funding alternatives, like the unsecured corporate debt market to finance consumer debt, while others are simply relying on their own deposit base to fund new loans.

"The significant inflow of deposits to commercial banks after the financial crisis and the increase in deposit insurance may make balance sheet funding a better option for credit card ABS issuers," said McElravey.

Issuance of credit card securities totaled $46 billion in 2009, with some help from the Federal Reserve's emergency loan facility. Some $100 billion of credit card securities are expected to mature this year in the ABS market. However, market participants expect a large part of that to be funded away from the ABS market.

Fed’s Sack Says Financial System Needs Leverage

Original posted on Bloomberg by Vivien Lou Chen and Candice Zachariahs:

Brian Sack, head of the markets group at the New York Fed, said the financial system can’t operate well without leverage and signaled that he supports the return of a “properly” structured securitization market.

“Securitization is a powerful vehicle that should play an important role in the intermediation of credit in the economy,” Sack said in a speech delivered by video conference from New York to an audience in Sydney. “We should also understand that a reduction in leverage to near zero in the financial system is not desirable.”

Sack’s comments come as U.S. lawmakers revamp regulation to prevent a recurrence of the financial crisis, which began with the collapse of the U.S. subprime-lending market in 2007 and led to about $1.76 trillion in losses and writedowns by banks and other financial institutions worldwide. Fed Governor Kevin Warsh, speaking yesterday in New York, said the securitization market will ultimately come back.

“To be sure, the expansion of securitized credit was much too extensive and its subsequent collapse was terribly disruptive, contributing significantly to the damage to the economy,” said Sack, 39, a former Fed economist and section head who returned to the central bank system last year.

“Those developments do not mean that securitized credit, if structured properly, should not return in size,” he said during the speech at the ACI 2010 World Congress. Derivatives are also “integral” to the functioning of financial markets, allowing risks to be redistributed, Sack said.

‘Operate Efficiently’

“The financial system cannot operate efficiently without leverage,” he said.

“Of course, much of the turmoil we witnessed across financial markets was due to the build-up of excessive leverage in the system, and we cannot miss the chance to learn from this painful lesson,” Sack said. Even so, the focus now should be in part “on how to make the use of leverage less pro-cyclical.”

Since December 2008, the Federal Open Market Committee has held the federal funds rate target for overnight loans between banks in a range of zero to 0.25 percent. Policy makers have also created unprecedented emergency programs to revive credit.

The FOMC in its public comments has “retained its flexibility” to extend the programs, Sack said in response to an audience question.

“It has not clarified under what conditions it would do so and presumably those conditions would depend on the behavior of long-term interest rates and on economic conditions more broadly,” he said. “I don’t think anything has been taken off the table.”

Friday, March 26, 2010

Recent ruling by Lehman court further complicates law on derivatives

Posted on Lexology by Barbara Rachel Parlin:

Decisions emerging from the Lehman Brothers chapter 11 cases are helping to define the parameters of the Bankruptcy Code’s safe harbors for derivative transactions (see Bankruptcy and Creditors’ Rights Alert, January 28, 2010). One ruling of note is the Bankruptcy Court’s recent decision in an adversary proceeding pitting Lehman against BNY Corporate Trustee Services (BNY) in its capacity as Indenture Trustee for certain credit-linked synthetic portfolio notes (the “Notes”). A Lehman-formed special purpose entity called Saphir Finance Public Limited Company (Saphir) was the issuer of the Notes and also was a party to a swap transaction with Lehman Brothers Special Financing (LBSF) in connection with the Notes transaction. The litigation involved competing claims by LBSF and the underlying Noteholders to certain collateral held by BNY, and the enforceability of a subordination clause (referred to as the “Noteholder Priority”) that purported to assign the Noteholders priority in the collateral over LBSF. The Bankruptcy Court’s decision makes new law as to the enforceability of contractual provisions that purport to change payment rights under a derivative contract as a result of a bankruptcy filing by a party or its credit support provider. The outcome also conflicts with a decision issued by the English High Court in companion litigation between Lehman, BNY and the underlying bondholder that currently is pending in England.

The Safe Harbors

When a debtor files a bankruptcy petition, an estate consisting of all of the debtor’s rights and interests in property, including contract rights, is created. With some notable exceptions, the Bankruptcy Code prohibits a non-debtor counterparty from exercising rights and remedies against the debtor or its property, or from continuing litigation against the debtor once the bankruptcy case is filed. Also, to facilitate a debtor’s ability to retain and/or realize value from its pre-petition contracts and to prevent forfeiture of valuable rights, the Bankruptcy Code renders certain types of contract provisions, such as those that cause a forfeiture of the debtor’s rights or permit a party to terminate a contract based on a debtor’s insolvency or the filing of a bankruptcy case (so called “ipso facto clauses”), unenforceable.

These types of protections are designed to prevent the forfeiture of valuable rights by the debtor. As a corollary, however, non-debtor counterparties may find themselves stuck in limbo while the debtor decides whether to assume, reject, or assume and assign their contracts, negotiate and confirm a plan, and pay claims. This delay and uncertainty is difficult for any business but can be particularly problematic for financial markets, which require parties to be able to timely close existing trades in order to engage in new ones. To prevent the policies underlying the Bankruptcy Code from disrupting financial markets, the Bankruptcy Code has been amended numerous times since it was first enacted in 1978 to include the so-called safe harbor provisions. These provisions are designed to neutralize the impact of a bankruptcy filing upon counterparties. Among other things, the safe harbors:

  • permit certain categories of counterparties to terminate existing securities, commodities, forward, repurchase, and swap agreements and master netting agreements relating to these types of instruments (collectively “Securities and Derivative Contracts”)
  • permit the exercise of contractual, exchange-specific or other rights to accelerate, liquidate, terminate or set-off under the parties’ Securities and Derivative Contracts
  • exempt certain prepetition settlement payments, margin payments and other transfers made in connection with Securities and Derivative Contracts from avoidance as a preference or a constructive fraudulent conveyance when such payments are made to or through certain categories of persons

In other words, when they apply, the safe harbor provisions protect counterparties to Securities and Derivative Contracts from being subject to the automatic stay, the prohibition against the enforcement of ipso facto clauses, avoidance claims and many of the other special protections afforded to debtors. More importantly, the existence and supposed reach of the safe harbors has come to affect market expectations about the risk associated with certain types of transactions involving derivatives.

BNY, Saphir and the Subordination Clause

In the BNY case, LBSF had priority rights in and to certain collateral held by BNY to secure payments due under the swap and the Notes, unless LBSF or its guarantor, Lehman Brothers Holdings, Inc. (LBHI), defaulted by, among other things, filing a bankruptcy case. If LBSF or LBHI defaulted, the Noteholder Priority provision would come into play and LBSF’s rights in the collateral would be subordinate to those of the Noteholders. Importantly, the Noteholder Priority provision was not included in the ISDA master agreement or schedules describing the terms of the swap that were entered into between Saphir and LBSF/LBHI, but rather was contained in the Notes agreements.

Saphir exercised its right to terminate the swap agreement between Saphir and LBSF in December 2008, and designated LBSF’s October 3, 2008 chapter 11 filing as the relevant event of default. Saphir’s termination of the swap triggered its obligation to redeem the Notes, in turn raising the question as to which group of Saphir’s creditors, LBSF or the Noteholders, had priority in the collateral being held by BNY (the termination resulted in a net payment being due to LBSF).

The Noteholders sought to enforce their rights in the collateral, eventually commencing an action in the English High Court against BNY for a declaration that the Noteholder Priority clause was valid and enforceable. At the same time, LBSF claimed that it had prior rights to the collateral and that the Noteholder Priority was an unenforceable ipso facto clause. LBSF and BNY each commenced adversary proceedings in the Bankruptcy Court to resolve this issue, and LBSF also intervened in the English litigation.

In August 2009, the English High Court ruled in favor of the Noteholders. Among other things, it determined that the Noteholder Priority clause was enforceable under English law and that it took effect on September 15, 2008, the date that LBHI filed its chapter 11 case. This ruling meant that, for purposes of English law, LBSF was not entitled to any priority in the collateral when it filed its own chapter 11 case on October 3, 2008, but the High Court did not purport to consider the effect that U.S. bankruptcy law might have on these issues. The High Court’s ruling was upheld on appeal in November 2009.

While the High Court proceedings were on appeal, BNY and LBSF each filed summary judgment motions in their adversary proceedings in the Bankruptcy Court. In its papers, BNY urged the Bankruptcy Court to defer to the High Court’s rulings, and argued that, in any case, the Noteholder Priority was enforceable under the Bankruptcy Code’s safe harbors. Although mindful of the complexities that would result from a ruling contrary to that issued by the English High Court, the Bankruptcy Court nevertheless rejected BNY’s arguments and ruled in favor of LBSF. In doing so, it made a number of important rulings.

First, the Bankruptcy Court found that the swap agreement between LBSF and Saphir was an executory contract, and that LBSF retained its priority rights in the collateral as of October 3, 2008, the date it filed its bankruptcy case. The Court based this holding on the fact that the swap agreement did not contain an automatic termination clause: since it did not terminate automatically, the swap continued in effect despite the filing of the LBHI and LBSF chapter 11 cases until Saphir sent its termination letter on December 1, 2008.

Second, even if the swap had terminated automatically on LBHI’s petition date, September 15, 2008 (a termination that would be protected by the Bankruptcy Code’s safe harbors), the Bankruptcy Court construed the Bankruptcy Code to bar a forfeiture based on the commencement of “a case” – not just “the case.” In other words, once a debtor is in bankruptcy, the Bankruptcy Code’s ipso facto protections apply to prevent the post-petition forfeiture of its rights whether the counterparty claims a default based on the commencement of the particular debtor’s bankruptcy case or the commencement of another debtor’s case. Although it recognized the “can of worms” opened by its finding that ipso facto protections can be triggered by the filing of another entity’s chapter 11 case, the Bankruptcy Court declined to provide guidance as to what kind of debtor to debtor relationship would trigger such protection.1 As such, the Bankruptcy Court found that, irrespective of whether it was triggered by LBSF’s filing or the earlier filing by LBHI, once LBSF was in bankruptcy, the Noteholder Priority was unenforceable as an ipso facto clause and any effort to enforce this provision would violate the automatic stay.

Third, the Bankruptcy Court found that the Noteholder Priority was not an act protected by the Bankruptcy Code safe harbors. The clause itself neither appeared nor was referred to in the ISDA master agreement, schedules or related confirmation that set out the terms of the swap agreement between LBSF and Saphir. Rather, the Noteholder Priority appeared in the Noteholder documents only. As such, the Bankruptcy Court held that while the Noteholder Priority may have dictated how the proceeds of the collateral would be distributed, it did not fall within the specific terms of the Bankruptcy Code safe harbor that permits the post-petition enforcement of clauses relating to the “liquidation, termination or acceleration” of a swap agreement.

While seeming almost like a “gotcha,” this holding actually is important because it signals that the safe harbors should be construed narrowly, limited to their specific terms whether or not the market viewed the swap and Note documents as part of one “integrated transaction.” There also is no certainty that the Bankruptcy Court would have found the Noteholder Priority or any similar provision affecting the distribution of proceeds of collateral to be covered by the safe harbors even if it had been included in the swap agreement itself. In any case, this holding is likely to effect how future agreements are drafted if only to avoid the possibility of a “gotcha” in a future case.

Finally, the Bankruptcy Court also held that the Noteholder Priority clause was not enforceable under section 510(a) of the Bankruptcy Code.2 It found that section 510(a) applies to subordination agreements in which the priorities are static from the outset, but does not apply when subordination is triggered by one party’s bankruptcy filing, as was the case here.


Cases involving large financial market participants such as Lehman do not come along very often. When they do, however, the resulting rulings can have a disproportionate impact on financial markets – even changing the ways that transactions are documented to account for potential litigation risks. For example, does this decision and the Bankruptcy Court’s prior ruling (in the Metavante matter) that termination rights are waived if not exercised timely weigh in favor of including an automatic termination provision in the derivative, or is it still better for counterparties to maintain flexibility to terminate? Does it matter if the ipso facto protection can be triggered by another party’s bankruptcy anyway? Should subordination or other provisions that change a party’s right to payment upon termination be included in the schedule to the derivative contract, and if so, will such provisions be construed as falling within the safe harbors?

The Bankruptcy Court’s decision in the BNY litigation reflects the trend of decisions emanating from the Lehman chapter 11 cases, which have interpreted the Bankruptcy Code safe harbors to have a narrow scope. Under the circumstances, market participants may require additional collateral or other types of security to protect them in the event that contractual provisions once thought to fall within the safe harbors are found to be outside their shelter. This, in turn, may increase the cost of derivatives for all parties.

Proposed securitization reforms under the revised financial reform bill in the U.S. Senate

Posted on Lexology by Melissa D. Beck, Kenneth Kohler and Jerry R. Marlatt:

On March 15, 2010, Senator Christopher Dodd (D-Connecticut), Chairman of the Committee on Banking, Housing and Urban Affairs of the U.S. Senate (the “Senate Banking Committee”), released a draft of a financial reform bill to be entitled the “Restoring American Financial Stability Act of 2010” (the “Dodd Bill”).

The Dodd Bill represents Senator Dodd’s second proposal of major financial reform legislation during the 111th Congress. His first attempt took the form of a discussion draft, the “Restoring American Financial Stability Act of 2009,” released on November 10, 2009 (the “November Senate Proposal”). One month following the release of the November Senate Proposal, on December 10, 2009, the U.S. House of Representatives passed its own version of major financial reform legislation, the “Wall Street Reform and Consumer Protection Act of 2009,” often referred to as the “Wall Street Reform Act” (the “House Bill”). All three versions of proposed financial reform legislation contain provisions intended to reform the securitization markets, focusing principally on the concept of “credit risk retention” that would require originators and securitizers of financial assets to retain a portion of the credit risk of securitized financial assets or, in more popular terms, to have “skin in the game.”

The final enactment of some version of these requirements appears to be some time off, notwithstanding the fact that the Obama Administration has declared the enactment of comprehensive financial reform legislation to be a top priority. Before final comprehensive financial reform legislation can be signed into law by the President, the Senate must pass its version of financial reform legislation (whether the Dodd Bill or some other version), a joint House-Senate Conference Committee would need to reconcile differences between the House Bill and the version ultimately adopted by the Senate, and a revised bill reflecting the reconciliation would need to be passed again by both Houses of Congress. Considering that many non-securitization provisions of the Dodd Bill are highly controversial and politicized, passage of financial reform legislation in the Senate may not be imminent.

Nonetheless, the securitization provisions of the Dodd Bill in many respects appear to reflect a convergence of the principles set forth in the November Senate Proposal and the House Bill, and therefore may be viewed as the most reliable indicator yet of the securitization related provisions that are likely to be contained in final financial reform legislation. The remainder of this Alert will describe the more significant securitization related provisions of the Dodd Bill and point out the principal differences between the Dodd Bill, on the one hand, and the November Senate Proposal and the House Bill, on the other hand.

Amount of Risk Retention

The Dodd Bill generally requires credit risk retention of 5% of any asset included in a securitization, or less than 5% if the assets meet underwriting standards to be established by regulation. In contrast, the November Senate Proposal would have required a credit risk retention of 10%. The House Bill also sets a baseline of credit risk retention percentage of 5% but, unlike the Dodd Bill, would permit the percentage to be increased at the discretion of the applicable regulator, as well as decreased, based on the underwriting standards used in the origination process and the due diligence procedures used in the securitization process.

Allocation of Risk Retention Percentage Between Securitizers and Originators

The Dodd Bill imposes risk retention requirements in the first instance upon securitizers (that is, issuers and sponsors of securitizations), but allows the regulators to allocate the risk retention percentage between the securitizer and the originator of the underlying financial assets. This is a fixed-sum game—the regulators must reduce the risk retention percentage imposed on a securitizer by the percentage imposed on the originator. The Dodd Bill also sets forth factors that the regulators must consider in determining the respective percentages of risk retention to be borne by securitizers and originators.

In contrast, the November Senate Proposal applied only to securitizers and not to originators. The House Bill applies to both securitizers and originators, and appears to allow for the independent imposition of risk retention requirements on securitizers and originators, potentially resulting in the imposition of a total requirement well in excess of 5% for any particular securitization.

Asset Class Differentiation

Under the Dodd Bill, underwriting standards and the amount of risk retention may be different for different asset classes as determined by regulation. The Dodd Bill specifies the asset classes to be treated separately as residential mortgages, commercial mortgages, commercial loans, auto loans and any other class of assets that the Office of the Comptroller of the Currency (“OCC”), the Federal Deposit Insurance Corporation (“FDIC”) and the Securities and Exchange Commission (“SEC”) deem appropriate. In contrast, neither the November Senate Proposal nor the House Bill contains provisions specifically calling for differential treatment of different asset classes.

Exemptions for Governmental Entities

The Dodd Bill does not exempt securitizations undertaken by government agencies or instrumentalities (although it does provide that the implementing regulations may exempt securitizations “as may be appropriate in the public interest or for the protection of investors”). In contrast, the November Senate Proposal exempted the U.S. government, U.S. government agencies and U.S. government sponsored enterprises (“GSEs”), presumably including Fannie Mae, Freddie Mac and Ginnie Mae, from the risk retention provisions. The House Bill similarly excludes securitizations backed by loans insured, guaranteed, administered or purchased by certain government agencies, including the Department of Education, the Department of Veterans Affairs, the Small Business Administration and Farmer Mac, but conspicuously does not exclude securitizations of Fannie Mae, Freddie Mac or Ginnie Mae or loans insured by the Department of Housing and Urban Development (“HUD”) (such as FHAinsured loans).

Regulatory Agencies Responsible for Rulemaking and Enforcement

The Dodd Bill gives primary responsibility for issuing implementing regulations to the OCC, the FDIC, and the SEC. Similarly, the OCC and the FDIC are given enforcement authority with respect to risk retention requirements over bank securitizers, while the SEC is given enforcement authority over non-bank securitizers. In contrast, the November Senate Proposal gave principal regulatory responsibility to the Federal Reserve Board, a new agency to be known as the Financial Institution Regulatory Administration, and the SEC. The House Bill gives rulemaking authority to a broad range of “appropriate agencies,” including the federal banking agencies, the SEC, the National Credit Union Administration Board, the Secretary of HUD and the Federal Housing Finance Agency.

Disclosure of Repurchase Requests

The Dodd Bill provides for regulations to require securitizers to disclose both fulfilled and unfulfilled repurchase requests. In contrast, the November Senate Proposal called for securitizers to disclose fulfilled (but not unfulfilled) repurchase requests aggregated by issuer, and the House Bill calls for originators to disclose fulfilled (but not unfulfilled) repurchase requests.

Due Diligence

The Dodd Bill requires issuers of asset-backed securities to perform due diligence on the underlying financial assets and to disclose the nature of that analysis. The November Senate Proposal contained a similar provision, while the House Bill does not include any similar requirement.

Effective Date

The credit risk retention provisions of the Dodd Bill would become effective for residential mortgage-backed securities one year after adoption of final rules under the risk retention provisions of the statute, and for other asset classes two years after adoption of final rules under the risk retention provisions of the statute. There are no comparable effectiveness provisions in either the November Senate Proposal or the House Bill.

Liquidity Risk, Derivatives and Arrow-Debreu Securities

By Jianbo Tian

Abstract: Instead to explain liquidity risk by the dramatically price fall during crisis, this paper build up a model to understand liquidity risk by bank's daily operation to match deposit uncertainty and loan demand uncertainty. The findings are: liquidity risk distinguished itself from credit risk by its own characteristics, which exists all the time and may trigger a crisis under the credit-risk-free environment; banks take derivatives as Arrow-Debreu securities to share and eliminate liquidity risk; more important, the limit of derivatives market is set up by the size of idiosyncratic liquidity risk. When banks and other financial institutions have an erroneously assumption that the derivative market is unlimited deep and overload the market, banking industry loses its capability to absorb any negative economic shock, and a small shock may trigger a crisis.

Download paper at:

Large parts of the securitisation markets remain stagnant. Not all efforts to reform them are helpful

Original posted in the Economist:

FOR most capital markets, the financial crisis resembled a stomach-churning bungee jump: a precipitous fall followed by a sharp rebound, albeit not to the heights enjoyed before the turmoil. The big exception was securitisation, large parts of which are still dangling near the ground. Even as it struggles to recover, the market that brought the world the joys of collateralised-debt obligations faces two stern tests: the phasing-out of central-bank support and a raft of tougher rules.

Securitisation’s boom and bust was spectacular. The packaging of mortgages, car loans, credit-card receivables and other debt to sell to capital-markets investors began to take off in the 1980s. By 2006 it was being used to channel around two-thirds of all residential mortgages and half of all consumer credit in America. By distributing loans, banks could cut their capital needs, allowing them to lend more. Hedge funds, insurers and the like gained access to a broader range of credit risks.

As the boom reached fever pitch, however, the quality of the loans being pooled into securities dived, especially in mortgages. When losses started to mount, asset-backed issuance dried up (see chart), forcing governments to take up the slack. In some parts of the market, they are now stepping aside again. The Federal Reserve is winding down its liquidity support for credit-card and car-loan transactions. Some $5 billion of prime, private-label car deals were priced in February. Structured vehicles for risky corporate loans are making a comeback, too.

By contrast, housing markets remain almost wholly reliant on government-backed agencies to package and guarantee mortgage-backed securities (MBSs). No residential MBSs have been sold in America without such backing for more than two years. Europe has seen a few private deals, but these were structured to be highly attractive to investors and acceptable as collateral at the European Central Bank’s discount window. No wonder Ralph Daloisio, chairman of the American Securitisation Forum, talked of an “existential” crisis in his speech to the industry group’s annual conference last month. He even wondered what Jean-Paul Sartre would make of it.

The prosaic reason for the dearth of private issuance is the wide gap between what investors demand and what borrowers will pay. “Jumbo prime” mortgages, decent-quality loans above the price threshold that Fannie Mae and Freddie Mac can buy at, are likely to be the first part of the new-origination market to come back. But it is currently non-economic to securitise these loans, says Laurie Goodman of Amherst Securities. To place a new issue, given the yields demanded by investors, the interest rate payable by borrowers must be 6.85%, a full percentage point higher than current levels. This differential is “the fundamental issue” for MBS markets, argues Tim Ryan of SIFMA, a securities-industry association. Rating agencies’ belated tightening of their methodologies has made this gap even harder to close.

The market for mortgage securities issued by Fannie and Freddie is also about to be tested. The Fed’s purchases of almost $1.25 trillion-worth of such MBSs since last year have helped keep rates near record lows. But this programme is due to expire at the end of March. Most think the effect of the Fed’s withdrawal will be muted, because the move has been telegraphed and because there is money on the sidelines waiting to take the Fed’s place. But rates are still expected to rise at a time when housing demand remains muted: sales of new homes hit a record low in February.

Investors also want the future shape of the industry to be clearer. On both sides of the Atlantic, lawmakers are struggling to strike the right balance between encouraging a revival of securitisation and protecting the financial system from the instability it can produce. Take the bill currently being debated in America’s Senate. Few would argue with its tightening of disclosure requirements, including more information on loan repurchases so that investors can better identify shoddy lenders. Similar calls are coming from central bankers, who want more data on the securities that they accept as collateral.

The benefits of the bill’s requirement that securitisers retain 5% of a deal’s credit risk are less clear. Toughening up the warranties that securitisers sign, agreeing to buy back duff loans, would have the same effect without tying up precious capital. And forced asset-retention could constitute “control” under new accounting rules. If so—no one seems sure either way—issuers would have to hold capital against the entire deal, not just the retained slice.

Another turn-off is the uncertainty surrounding “safe harbour” rules, which were created to reassure investors in securitised assets that they would continue to receive payments if a sponsoring bank failed. Revisions proposed by the Federal Deposit Insurance Corporation (FDIC)—on hold for now—would punch holes in this ring fence, say industry groups.

A more immediate worry is the cacophony of competing interests exposed by the downturn. Banks that service mortgages, for instance, are reluctant to forgive principal, even if that would benefit borrowers and investors, because it would trigger write-downs of second-lien loans on the banks’ own books. One investor likens mortgage securitisation to “class warfare” (although Bank of America’s decision to forgive some principal on a limited number of loans may herald a wider ceasefire).

For many, the most off-putting factor is the question-mark hanging over Fannie and Freddie, which have been in government conservatorship since September 2008. Until their role is clarified, the future shape of the market, and the opportunities for private competitors, are unknowable. In testimony this week Timothy Geithner, America’s treasury secretary, said that he was committed to encouraging private capital back into the market and to shaking up the two agencies. But no details were offered. Amid such uncertainty “only a madman would ramp up securitisation efforts now,” says one banker.

Thursday, March 25, 2010

Tighter OTC derivatives rules loom

Original posted in FT Alphaville by Aline van Duyn:

Regulators are to unveil tough rules in the coming weeks that will require trading information in over-the-counter derivatives - including the identity of investors - to be easily passed on to global financial watchdogs.

The rules, being formulated by the 40-member OTC Derivatives Regulators' Forum - which includes the Federal Reserve and the Securities and Exchange Commission from the US, the UK's Financial Services Authority and European banking regulators - will apply to credit, interest rate and equity derivatives traded off exchange.

The rules come on the back of a transatlantic row over the lack of disclosure to regulators of credit derivatives trades in Greek debt. This pushed the body in charge of collecting global data for credit derivatives - the DTCC Trade Information Warehouse - to reveal more information to financial watchdogs.

Fresh guidelines from the DTCC, made public this week, will give regulators "unfettered access" to its information, including the identity of trading counterparties. Under its previous rules, the DTCC revealed counterparties only with their prior consent.

The heightened transparency, which is likely to apply to trade warehouses or repositories for interest rate derivatives and equity derivatives, shows the direction regulators are leaning.

"If someone like the SEC wants to investigate insider trading, the idea is that they can go to a single source, and get trades on credit derivatives on a particular US company," said one regulator involved in the talks.

"If the Greek authorities want to investigate who's trading in Greek [credit default swaps], they should be able to do this easily too."

The opacity of the privately traded OTC derivatives market became strikingly clear after undetected CDS exposure at AIG led to its near-collapse and required a bail-out of the insurance company by the US government.

That plus fears of a chain reaction of losses if derivatives dealers went bust - as nearly happened with the demise of Bear Stearns and bankruptcy of Lehman Brothers - and the growing influence of derivatives prices on trading in shares has led to the creation of information warehouses for derivatives.

Most progress has been made in credit derivatives. The Depository Trust & Clearing Corporation, a large provider of post-trade services such as clearing, set up the credit derivatives warehouse last year. It has become an important information source for regulators on credit derivatives.

TriOptima, a Swedish group, is setting up a warehouse for global interest rate swaps and the DTCC is setting up a warehouse for OTC equity derivatives.

The role of margin requirements and haircuts in procyclicality (BIS CGFS Working Paper)

Abstract: Terms and conditions on secured lending transactions, as well as the changes to the eligible pool of collateral securities and the applicable haircuts on them, affect the access to credit and risk-taking behaviour of leveraged market participants. The study group report on The role of margin requirements and haircuts in procyclicality under the chairmanship of David Longworth of Bank of Canada reviews market practices for setting credit terms applicable to securities lending and over-the-counter derivatives transactions with a view to assess how these practices may contribute to financial system procyclicality. The report recommends a series of policy options, including some for consideration, directed at margining practices to dampen the build-up of leverage in good times and soften the systemic impact of the subsequent deleveraging.

Download the paper here:

“Cream‐Skimming” in Subprime Mortgage Securitization

By Paul Calem, Christopher Henderson and Jonathan Liles:

Abstract: Depository institutions may use information advantages along dimensions not observed or considered by outside parties to “cream‐skim,” meaning to transfer risk to na├»ve, uninformed, or unconcerned investors through the sale or securitization process. This paper examines whether “creamskimming” behavior was common practice in the subprime mortgage securitization market prior to its collapse in 2007. Using Home Mortgage Disclosure Act data merged with data on subprime loan delinquency by ZIP code, we examine the bank decision to sell (securitize) subprime mortgages originated in 2005 and 2006. We find that the likelihood of sale increases with risk along dimensions observable to banks but not likely observed or considered by investors. Thus, in the context of the subprime lending boom, the evidence supports the cream‐skimming view.

Download the paper here:

Wednesday, March 24, 2010

Canadian budget has implications for the structured finance market

Original posted on Stikeman Elliott's web page by Mark E. McElheran

The 2010 Canadian federal budget was delivered on March 4, 2010. The budget contains a number of interesting developments and implications for the Canadian structured finance market.
CSCF ends amid signs of life in the securitization market
The budget confirmed that the Canadian Secured Credit Facility (CSCF) provided by the Business Development Bank of Canada (BDC) will, as originally contemplated, conclude at the end of March 2010. In the view of the federal government, the CSCF is having a positive impact on the availability and cost of financing for vehicles and equipment. BDC has posted details of completed transactions (all of which have been completed by way of public prospectus offerings) on the BDC website.

New financing initiative for equipment and vehicles
While the CSCF may be drawing to a close, the budget announced the creation of the Vehicle and Equipment Financing Partnership as part of the Business Credit Availability Program, which forms part of Canada's Economic Action Plan. This program will be funded and managed by the BDC with an initial allocation of $500 million in funding. The program is intended to provide financing for small and medium-sized finance and leasing companies. Further details are to be announced in the coming weeks. Hopefully this program, in conjunction with an increasingly vibrant securitization market, will provide a much needed boost to this sector.
Covered bonds
A number of Canadian banks have already entered the European and domestic covered bond market but news from the budget indicates that there may be increased activity ahead. The government has indicated that it intends on developing a legislative framework for the issuance of covered bonds in order to encourage investment and assist federally regulated financial institutions in diversifying their funding sources. There are no indications as of yet as to the anticipated timeline, but this is an encouraging sign for the covered bond market, which has a lengthy history in Europe but has only in recent years been accessed by Canadian issuers.

Stress Testing Credit Risk: The Great Depression Scenario

Posted on SSRN by Simone Varotto

Abstract: By using Moody’s historical corporate default histories we explore the implications of scenarios based on the Great Depression for banks’ economic capital and for existing and proposed regulatory capital requirements. By assuming different degrees of portfolio illiquidity, we then investigate the relationship between liquidity and credit risk and employ our findings to estimate the Incremental Risk Charge (IRC), the new credit risk capital add-on introduced by the Basel Committee for the trading book. Finally, we compare our IRC estimates with stressed market risk measures derived from a sample of corporate bond indices encompassing the recent financial crisis. This allows us to determine the extent to which trading book capital would change in stress conditions under newly proposed rules. We find that, typically, banking book regulation leads to minimum capital levels that would enable banks to withstand Great Depression-like events, except when their portfolios have long average maturity. We also show that although the IRC in the trading book may be considerable, the capital needed to absorb market risk related losses in stressed scenarios can be more than twenty times larger.

Download the paper here:

The Long View of Financial Risk

Posted on SSRN by Lisa R. Goldberg and Michael Y. Hayes (MSCI Barra)

Abstract: We discuss a practical and effective extension of portfolio risk management and construction best practices to account for extreme events. The central element of the extension is (expected) shortfall, which is the expected loss given that a value-at-risk limit is breached. Shortfall is the most basic measure of extreme risk, and unlike volatility and value at risk, it probes the tails of portfolio return and profit/loss distributions. Consequently, shortfall is (in principle) a guide to allocating reserve capital. Since it is a convex measure, shortfall can (again, in principle) be used as an optimization constraint either alone or in combination with volatility. “In principle” becomes “in practice” only if shortfall can be forecast accurately. A recent body of research uses factor models to generate robust, empirically accurate shortfall forecasts that can be analyzed with standard risk management tools such as betas, risk budgets and factor correlations. An important insight is that a long history of returns to risk factors can inform short-horizon shortfall forecasts in a meaningful way.

Download an older version of the paper here:

Credit Default Swaps and the Empty Creditor Problem

Posted on SSRN by Patrick Bolton and Martin Oehmke

Abstract: A number of commentators have raised concerns about the empty creditor problem that arises when a debtholder has obtained insurance against default but otherwise retains control rights in and outside bankruptcy. We analyze this problem from an ex-ante and ex-post perspective in a formal model of debt with limited commitment, by comparing contracting outcomes with and without credit default swaps (CDS). We show that CDS, and the empty creditors they give rise to, have important ex-ante commitment benefits: By strengthening creditors' bargaining power they raise the debtor’s pledgeable income and help reduce the incidence of strategic default. However, we also show that lenders will over-insure in equilibrium, giving rise to an inefficiently high incidence of costly bankruptcy. We discuss a number of remedies that have been proposed to overcome the inefficiency resulting from excess insurance.

Download the paper here:

OTC Interest Rate Swaps and Beyond (Tabb Group)

The financial markets have been targeted in a series of industry reform debates involving the Obama administration, legislators, regulators, market stakeholders and the mainstream media. Given their global size and their potential to destabilize, if not topple, major financial intermediaries, the OTC derivatives markets have become a primary focus of the international debate.

The complex and insular world of OTC derivatives prohibits a comprehensive understanding of the relevant issues by legislators and the public at large. This lack of understanding leads to significant confusion and an ill-informed debate. But despite this confusion, the goals of reform for these markets are quite clear: to minimize counterparty credit risk and enhance market transparency. Solutions to achieve these goals – which already have broad agreement – are also clear. There are four general proposals, including:

? Enhance price discovery and straight-through processing efficiencies by migrating from bilateral and manual to multilateral and automated trading mechanisms;
? Maximize the use of central counterparties to mutualize credit risk through greater netting efficiencies and the establishment of a well-defined default management process;
? Optimize financial counterbalances with improved collateral management infrastructure for the remaining subset of bilateral deals; and
? Amplify regulatory response tools with comprehensive, granular and timely trade repositories.

Practical implementations of each of these proposals are available today, all of which pre-date the recent economic crisis and the ensuing glare of the spotlight, in some cases by as much as several years. TABB Group believes that as much as 30% of all interest rate swaps will be cleared through a central counterparty by year-end 2009, a result of growth rates in the adoption of CCPs measuring higher than market growth as a whole. Other important industry initiatives are adding to the penetration, including dealer-to-customer clearing and a greater global focus on reducing counterparty risk. All of these efforts amount to an unprecedented makeover of longstanding protocols in the OTC marketplace.

Upon completion of these industry “upgrades”, the vast majority of all interest rate swaps and a material portion of other OTC derivative asset classes will be centrally cleared. In addition, comprehensive and timely trade transparency will give regulators more of the necessary tools they need to increase effective management of market disruptions. As a result, the interconnected global financial markets will be much safer than today, and the ripple effects from the default of a major financial intermediary will be significantly buffered.

However, electronic trading platforms remain a key ingredient to future advancements and today represent the “missing link” of meaningful improvements. Although the implementation of proposed solutions has intensified, claiming victory for the combined impact of these initiatives means finding a way for the adoption of electronic trading to be dramatically increased, providing the opportunity for further reduction of risks and the evolution to a more efficient marketplace.

The major broker-dealers – those who are the counterparty to just about every trade in these markets– remain largely on the sidelines in order to maintain and protect their valuable OTC franchises. The main challenge is to inspire or convince dealers to give up their phones in favor of an automated execution solution.

The chain of events that will ultimately foster this adoption currently presents itself as an unsolvable puzzle - the financial markets’ equivalent of a “Gordian knot”. Fortunately, this is not a metaphysical puzzle, but a question of whether it will be solved by volition or mandate – and when.

The TABB Group Study on OTC Interest Rate Swaps and Beyond: The Path to Electronic Markets
This 30-page report discusses the main goals and objectives for improving the safety of the OTC interest rate swaps market – and the OTC derivatives markets, as a whole – by moving transactions away from the inherent credit and operational risks of bilateral deals, enhancing neutral and transparent price discovery, and further promoting full workflow processing efficiencies, all while preserving flexibility in deal construction. The report defines the four broad proposals to address the aforementioned goals, with “organized markets” being the proposal that involves the most disagreement, and central credit counterparties (CCPs) being the proposal with the greatest consensus. The report also outlines how adoption of electronic platforms are the missing link to completion of these market enhancements, the primary challenges to the completion of this market upgrade, and the strategies that end users can employ to overcome them.

Derivatives doubt likely to hit bank revenues

Posted in the Financial Times by Aline van Duyn and Michael Mackenzie:

The future shape of the derivatives markets, one of the big sources of revenue and profits for Wall Street banks, is still incredibly hard to map out.

In the US, Republicans and Democrats last week failed in their efforts to reach agreement on rules requiring most privately traded, or over-the-counter, derivatives to pass through a central clearing house. As a result, there are unanswered questions about the final shape – and timing – of this legislation.

“[Bi-partisan] talks on derivatives reform have collapsed, which we believe significantly diminishes the prospects for OTC derivatives reform becoming law this year,” say analysts at Keefe, Bruyette & Woods.

Even if new laws remain elusive, moves to bring many of the privately negotiated contracts for credit default swaps, interest rate swaps and other derivatives into clearing houses have started to take place anyway. In theory, this should reduce the risks of systemic collapse to the global financial system if a derivatives dealer goes bust, as the clearing house takes on the risks of such a default.

Yet even as clearing is embraced – including by many of the big derivatives dealers such as Bank of America, Barclays Capital, Deutsche Bank, Goldman Sachs, JP Morgan and Morgan Stanley – there remain a lot of profits to fight for.

In a recent report about the banking industry, Morgan Stanley and consultants Oliver Wyman estimated that 2010 revenues for large banks from the credit and securitisation businesses are projected to decline by 40 per cent from 2009 levels to $33bn. One key reason for this drop are the regulatory threats to securitisation and credit derivatives, both in terms of calls for increased capital and clearing. What happens after this year is uncertain.

“We expect the OTC flow markets to be dramatically reshaped,” the report says. “In our base case, we assume the sell-side margin erosion is largely offset by increased volumes, imp­roved cost structure and balance sheet efficiency. However, the bear case scenario of regulatory enforced exchange trading or severe loss of liquidity via badly thought through central counterparty solutions remains a distinct possibility.”

What complicates the debate in terms of future profits from derivatives – and costs for users – is the double uncertainty about the impact on markets of clearing and potential price reporting rules and exchange trading requirements, and rules from global regulators such as the Basel Committee about the amount of capital banks should have to hold for derivatives trades and positions.

Tabb Group estimates that there is $40bn in annual revenues in global OTC derivatives, excluding credit derivatives, in play for the top 20 dealers.

Regulators are expected to require less capital for cleared derivatives – a business that is only being done by a handful of clearing houses – because of the risks that uncleared markets pose to the safety of the financial system.

A key issue is how much more is required for uncleared derivatives, and whether or not such capital rules will take into account positions that in theory offset each other.

Indeed, even if banks or other big users of derivatives such as some non-financial companies are able to avoid centralised clearing or the reporting of prices at which deri­vatives trade, they may still face higher costs for using derivatives through capital charges.

However, there may be a shift in timing.

“The train has left the station on clearing more OTC derivatives and this legislative stalemate gives dealers more time to take control of their own destiny and move towards clearing in their own time,” say the Keefe, Bruyette and Woods analysts. “It also gives the US regulators some breathing space for the international regulators to get on board.”

While much attention is focused on credit derivatives, this sector is dwarfed by the interest rate sector. These are now particularly in focus after the regulator of mortgage agencies Fannie Mae and Freddie Mac announced this month that the two lenders would press ahead with using clearing houses for their swaps portfolios this year – whether or not legislation was passed.

Interest rate derivatives account for more than 70 per cent of the global OTC market at a notional value of $437,000bn, with interest rate swaps clocking in at $342,000bn in notional exposure, according to the Bank of International Settlements.

About 25 per cent of that market is pushed through central clearing, a figure that could rise to 65 per cent by 2012, says Tabb Group.

“For many years, much-needed modernisation has been put on hold and the status quo has been preserved,” says Paul Rowady, senior analyst at Tabb Group. “The remaining challenge is how to inspire, convince or otherwise incentivise major dealers to move to more automated execution.”

Big clearing houses set for OTC boost

Posted in the Financial Times by Jeremy Grant:

While the shift of over-the-counter (OTC) derivatives on to clearing houses may seem like a great business opportunity, it is one that is likely to benefit the incumbents.

That is because clearing houses tend to be natural monopolies. Business is hard to prise away from a house that already controls clearing of certain products – as the exchange-traded futures markets show.

CME Group clears virtually all US futures contracts, because they are traded on its Chicago Mercantile Exchange unit – and are cleared through CME’s in-house clearer.

Being a “first mover” also helps, as IntercontinentalExchange has shown by quickly dominating clearing in credit default swaps.

The start-up costs associated with establishing a clearing business are huge. A clearing house needs to attract clearing members, which lodge margin with it and contribute to a “default fund”, the ultimate financial backstop. The big clearing houses either owned by or servicing existing exchanges already have these in place, as well as well-developed risk management.

None of this has deterred Nasdaq OMX, which controls International Derivatives Clearing Group, a new clearer for interest rate swaps. It recently signed up as clearing members Newedge and MF Global, two of the world’s largest publicly listed futures brokers.

There are doubts over how much of the OTC derivatives markets it is feasible to clear beyond interest rate swaps, CDS and FX, where the incumbents, including LCH.Clearnet in Europe, have already made their intentions clear.

Anthony Belchambers, chief executive of the Futures and Options Association, says:

“In some cases the smaller, lower-volume OTC markets or ones that are highly volatile are going to be loss-leaders for clearing houses.”

DTCC to provide counterparty-specific CDS data to regulators

Posted in the Financial Times by Aline van Duyn:

A transatlantic row that flared up in the wake of the Greek debt crisis over the lack of disclosure to regulators of credit market activity has pushed the new body in charge of collecting global trading data to provide more information to financial watchdogs.

Regulators from around the globe including the Securities and Exchange Commission will now be able to obtain breakdowns of trading activity in credit default swaps, including the identity of the investors.

This follows a U-turn by the DTCC Trade Information Warehouse, a body set up in the wake of the financial crisis to allow regulators to track positions and trading in over-the-counter credit derivatives.

Regulators involved in the dispute said the DTCC had initially resisted making available such details on Greek CDS, a type of insurance against the risk of debt default. Speculation in these instruments has been blamed by European politicians for heightening the Greek debt crisis.

Some European regulators were so concerned about being unable to obtain data to determine whether investors were manipulating markets that they were planning to call for a rival credit derivatives data collector in Europe, according to people involved in the discussions.

The DTCC said this was not an issue, however. ”It is a bedrock principle of the warehouse that all interested regulators should have unfettered access to warehouse information necessary in furtherance of their respective regulatory missions,” the letter said.

The DTCC Trade Information Warehouse was set up as a not-for-profit co-operative run by the Depository Trust & Clearing Corporation, the large provider of post-trade services in charge of clearing activities in the US.

In a letter sent to regulators last week and seen by the Financial Times, the DTCC said that “regulators and other governmental entities can expect that, upon the formal request of any regulator, counterparty names will be included in both aggregate and trade-level information provided by the warehouse”.

The DTCC had previously agreed with the banks and dealers that provide trade information that it would not reveal details of counterparties unless they had their explicit consent.

“There is always a balance between customer confidentiality and regulatory interests,” said a DTCC spokesperson. “In light of recent events, it has shifted slightly.”

The rules governing the sharing of trading information in OTC markets are still being worked out.

Download the DTCC press release here:

Tuesday, March 23, 2010

Interest-Rate Deals Sting Cities, States

Original posted in the Wall Street Journal by Aaron Lucchetti:

Buyer's remorse has hit some cities and states that did deals with Wall Street in different times.

Hundreds of U.S. municipalities are losing money on interest-rate bets they made during the bull market in hopes of protecting themselves from higher rates. The deals backfired when rates fell, shriveling the sums paid to municipalities. Now some are criticizing Wall Street and trying to exit the contracts.

The Los Angeles city council approved a measure this month instructing city officials to try to renegotiate an interest-rate deal with Bank of New York Mellon Corp. and Belgian-French bank Dexia SA. The pact, reached in 2006 to help fund the city's wastewater system, currently is costing the city about $20 million a year. The banks declined to say how they would respond to a request to renegotiate.

In Pennsylvania, 107 school districts entered into interest-rate swap agreements from October 2003 to last June. At least three have terminated them. Under one deal, the Bethlehem, Pa., school district had to pay $12.3 million to terminate a swap with J.P Morgan Chase & Co., according to state auditor general Jack Wagner. J.P. Morgan declined to comment.

State lawmakers have proposed restrictions on municipalities' ability to use swaps. "It's gambling with the public's money," Mr. Wagner said. "Elected officials are simply no match for the investment banker that's selling the deal."

Examples of Interest-Rate Swaps

This study by the Service Employees International Union, which represents municipal employees, is based on government filings and payment estimates using current interest rates. It compares the interest-rate swap payments of cities with their budget outlooks. The payments don't reflect corresponding moves in municipal bonds. Included with some examples are securities firms that entered into the transactions with the municipalities.

The Service Employees International Union said Chicago, Denver, Kansas City, Mo., Philadelphia, Massachusetts, New Jersey, New York and Oregon all are in the hole on swaps agreements they made with financial firms. The required payments range from a few million dollars to more than $100 million a year, the union said.

Such deals are deepening the misery faced by state and local governments throughout the U.S., already facing their worst financial squeeze in decades because of shrinking tax revenue and stubbornly high pensions and other costs.

America's states and cities may be going bankrupt, but investors shouldn't worry. Dow Jones Adviser columnist James Altucher explains.

Government agencies that saw the transactions as a cushion against fiscal surprises now are being squeezed by the arrangements. The supply of municipal derivatives swelled to more than $500 billion before falling in the past two years, estimates Matt Fabian, managing director at research firm Municipal Market Advisors. Moody's Investors Service says the surge was fueled by Wall Street marketing efforts, demand from state and local governments and "relatively permissive" statutes on the use of swaps in Pennsylvania and Tennessee, both of which are taking steps to tighten rules.

Many of the deals generated higher fees for securities firms than traditional fixed-rate debt. Government officials, for their part, entered the deals in hopes of reducing borrowing costs.

The swaps were introduced in many cases along with floating-rate debt that municipalities issued because it was cheaper than traditional fixed-rate debt. Lower interest rates have served them well on this; their borrowing got cheaper.

But municipalities also added swaps to the mix, promising to pay a fixed rate to banks, often 3% or more, while receiving payments from banks that vary with interest rates. On the swaps, the municipalities generally have been losers, as the interest that banks have to pay them have often fallen below 0.5%.

Government budgets are stretched thin, prompting officials to look for dollars wherever they can. The clashes over the swaps come amid growing scrutiny of the municipal-bond market, where the U.S. government is investigating whether there was bid rigging in certain cases.

Wall Street firms say no one was complaining when the deals were helping municipalities save. Defenders of swaps say they still can help cities if paired with the right borrowing strategy.

Some securities-industry officials say they are open to renegotiating with municipalities so long as doing do doesn't cause a tidal wave of demands.

"If they can't come to an agreement on how to modify, the contract should stand," said Michael Decker, a managing director at the Securities Industry and Financial Markets Association, a trade group.

Escaping isn't cheap or easy. Under a transaction between Oakland, Calif., and a Goldman Sachs Group-backed venture, Goldman paid the city $15 million in 1997 and $6 million in 2003, according to Oakland financial reports. But now, the city stands to lose about $5 million this year.

That money "is coming out of taxpayers' pockets and could be used for other things," said Rebecca Kaplan, a city council member. She wants the city to renegotiate. But the city faces a $19 million termination payment. Oakland officials didn't respond to requests for comment.

Some deals have led to court. Last August, a unit of bond insurer Ambac Financial Group sued the Bay Area Toll Authority for payments it said it was owed under various swap agreements. The authority paid Ambac $104.6 million to terminate the swaps after the insurer's credit ratings were downgraded and bonds associated with the swaps were retired. Ambac claims it is owed $156.6 million under the agreements.

The toll authority, which is fighting the claim, said it made the payment, and Ambac sued for the other part of what it says it is owed. An Ambac lawyer couldn't be reached for comment.


Next month, Richmond, Calif., is expected to restructure a $65 million agreement with Royal Bank of Canada that could cost the struggling city an estimated $3.5 million a year, based on current interest rates. Under the revised deal, Richmond would make smaller, more regular payments to the bank over time.

In November, RBC and city officials rejiggered a separate transaction that would have cost Richmond about $2.5 million. An RBC spokesman said bank officials are working with the city to "restructure the underlying bonds in a way that best serves the city's interests and those of its residents."

The "goal of the original transaction was to lower borrowing costs for the city," the bank spokesman said, adding that the bonds didn't perform s anticipated because of downgrades at bond insurers that backed them.

Richmond's vice mayor, Jeff Ritterman, said he still is reviewing next month's proposed restructuring. Financial woes have forced Richmond to cut its budget and lay off employees.

Alabama and Milan make bankers nervous

Original published in the Financial Times by Gillian Tett:

Are the urbane, excitable citizens of Milan “sophisticated”? What about those of Alabama, USA? That is a question that could – and should – soon be provoking a welter of debate.

For while Alabama and Milan are rarely mentioned in the same breath, both locations now share something: they are making bankers nervous.

The reason is derivatives. Earlier this week, the city of Milan announced that it is suing Deutsche, UBS, JPMorgan and Depfa, for allegedly misleading the city on swaps that adjusted interest payments on some €1.7bn ($2.3bn) of deals. The banks deny the allegations relating to the case. The trial is scheduled to start in May.

Meanwhile, on the other side of the Atlantic – if not cultural spectrum – another battle has recently played out in relation to bonds and swaps arranged by JPMorgan for the city of Birmingham in Jefferson County, Alabama. Late last year, JPMorgan agreed to pay a $25m civil fine, make a $50m payment to Jefferson County and forfeit $647m in termination fees linked to swaps deals. This came after the Securities and Exchange Commission accused JPMorgan of malpractice (a claim that the bank neither admitted nor denied on settlement).

Now, I have no idea whether an Alabama-style settlement will emerge in Milan too: the legal systems differ, as do the details of the contested trades. However, the really interesting issue is whether this could be about to spark a wider trend.

After all – and as the Financial Times reported recently – the Milan deals are just the tip of an iceberg of complex financial deals that have been cut in recent years with Italian entities (including even religious orders). Moreover, those Italian deals are just one fragment of a vast global web of transactions that investment banks have sold to public, and quasi-public entities.

I daresay most of those deals have been arranged in transparent circumstances. Probably many have also left the clients happy. But some have not, particularly in the aftermath of the credit crisis. Thus, the scenario that now worries some senior bankers is that other western municipalities will look at the tale of Birmingham – or Milan – and lodge their own lawsuits.

The pain might not stop there. Many local government entities are saddled with public debt that they will struggle to repay. They also know that it is currently fashionable for politicians of all stripes to bash the banks. It is thus easy to imagine a scenario where some local government entities are soon tempted to seek haircuts on derivatives deals in all manner of ways (including legal suits).

And what makes that scenario doubly alarming for banks is that public sector entities do not usually post collateral when they cut derivatives deals; nor do banks usually price them to take account of future potential legal costs. The net result, in other words, is that some senior bankers are now quietly wondering if it is time for them to rethink how they assess and price municipal or local government risk.

Whether they will actually do that, remains to be seen. But as the anxiety swirls there is another issue where there is now an even more tangible need for a rethink – the question of what constitutes a “sophisticated” investor.

After all, a key reason why the banks have been able to stuff so many controversial deals into local authorities in recent years is that most bankers and regulators have assumed the world could be divided into two categories. In one box sat retail investors who were safeguarded by consumer protection laws; in the other, sat non-retail – such as Milan – who were considered to be “sophisticated”, and thus fair game for the banks’ sales teams. Caveat emptor. But the story of Italy (or Alabama) shows that this two-tier distinction is nuts. Some non-retail investors, such as hedge funds, are “sophisticated”, but many pension funds, or public sector entities are not. (In Italy, for example, some government officials purchasing the deals could not even read the English-language contracts).

If nothing else, this suggests that regulators badly need to rethink the two-tiered distinction (perhaps by creating a third, middle category of investors who are neither retail, nor fair game for banks.) In the coming months, Mary Schapiro, head of the SEC, is likely to do precisely that, by calling for a new definition of “sophisticated” investors. European regulators may do the same.

However, the banks need to act too, by voluntarily rethinking their definition of “sophisticated” clients. Doing that will not necessarily stave off lawsuits linked to past deals. But it might let them get ahead of the political curve, and even save costs in the long run. After all, legal disputes are costly for everyone (except lawyers) – not just in Milan, but Alabama too, not to mention all the other jurisdictions where more drama could yet emerge.

Comment letter from Adrian Jack:

Sir, Gillian Tett (“Transatlantic losses spark a sophisticated financial debate”, Insight March 19) overlooks a key factor in the litigation between local governments and the banks over derivatives and swaps. In a hedging contract, typically one party will accept a short-term loss for a chance of long-term gain while the other will take a short-term gain against the long-term risk. Entities controlled by politicians, such as cities and municipalities, will invariably prefer the latter position. The politicos get the kudos of the up-front money. But when the bets go sour, they will have moved on, or (even better!) the opposition party will be in power and will have to suffer the opprobrium and clean up the mess. Banks arranging the deals are aiding and abetting this conflict of interest on the part of the politicians. This is at the heart of the litigation.

Adrian Jack,
Barrister and Rechtsanwalt,
Enterprise Chambers,
London WC2, UK